Updates Extracts from Aviation Strategy, comments on aviation developments, news from Aviation Economics. Cycles in perspective Crunching credit and soaring fuel is clearly not a good combination for the aviation industry. Citing these adverse developments, IATA has come out with a forecast that sees a cyclical downturn in 2008 and identifies 2007 as the peak of the market. This means, using IATAs definition of the cycle in terms of global net profit/loss, that the recent upturn is very truncated. However, it is becoming more difficult to interpret the significance of an agglomerated forecast in an aviation world that is becoming less and less homogenous. One of the features of the aviation scene in recent years has been the contrast between the US network carrier sector - which has been characterised by low growth, drawn-out labour negotiations and downsizing by the Legacy carriers, with minimal investment in new equipment - and the rest of the developed world. This is a huge generalisation of course, but in Europe the main network carriers are all enjoying success with variations on the global hub strategy, the Middle East super-connectors remain overwhelmingly ambitious, and SIA is pioneering the A380. Even the US LCC sector, despite the continued solid performance of Southwest and the innovative alliance strategies of JetBlue, has not been anywhere near as dynamic as Europe, where Ryanair continues to produce excellent financial results, expand its network and continuously minimalise the short haul product, to the dismay of some, to the delight of others. So it is disturbing that IATA reckons that the North America regions net profit will fall from an estimated $2.7bn in 2007 to $2.2bn in 2008 (this decline accounts for almost all of the forecast global downturn). This certainly goes against the perception that some of the Legacies are now in a strong position to reap benefits from their Chapter 11 restructurings. Then IATA is projecting a paltry $2bn net profit for Europe. But the four network carriers (Air France/KLM, BA, Lufthansa and Iberia) combined net profits for next year are currently being forecast by equity analysts at around $6.5bn while the big two LCCs Ryanair and easyJet will add a further $1.1bn or so. One wonders who is going to make the counterbalancing massive losses Alitalia cant do it all on its own. The US/rest of the world split is also reflected in apparently contrasting views of the state of the aircraft market. In the US many leading airline executives and financiers attribute the lack of profitability in the Legacy sector to systemic overcapacity and plead the case for mergers to rationalise the business. In Europe and particularly in the emergent aviation markets of the Middle East, India and China, there is a widespread view of the aircraft market as being under-supplied relative to demand, which has resulted in lease rates for modern narrowbodies doubling over the past five years, a strong escalation in second-hand prices and excessively long waiting period for deliveries of new orders. From this perspective, a cyclical peak probably has been reached, and a slowdown would even be beneficial in taking some of the heat out of the market. Backlog hits record There are no signs of orders slowing and the backlog has reached record levels - 5,740 commercial jets on firm order as of mid-May, about 29% of the global fleet, with another 1,900 or so on option. The last time the backlog got close to this level, in proportionate terms, was in 1990 when the lessors, particularly GPA, were attempting to dominate the production schedules. That all ended with a serious airline recession and the collapse of GPA and other lessors. This time around there are differences. The airline industry no longer seems to be in thrall to the global GDP cycle, partly because in a low-inflation world the cycle seems to have smoothed out, unless we are deluding ourselves. Also, India and China are now major generators of aircraft demand, with 15% of aircraft on order. By contrast, US carriers currently only account for 10% of the backlog. Narrowbodies account for two thirds of the aircraft on order, which is of course largely a reflection of the LCC phenomenon, and this is the major difference between now and the early 1990s - a structural change in the industry with a more efficient operating model replacing an outmoded version in the short/medium haul markets. The demand for new narrowbodies is such that at current production rates the backlogs equate to about six and half years of deliveries for A320s and five and half years for 737-800s. There is a major incentive for airlines to maximise order volumes as far as the finance will stretch - in order to achieve the lowest possible unit price and to leverage negotiations on delivery slots. It can all go wrong, however, if the market that these aircraft are delivered into turns out to be too small or too competitive to absorb them. There would appear to be potential for rationalisation within the backlog, with weaker customers forced to surrender their slots to stronger competitors. Or there is the possibility that some of the airlines with substantial orders might evolve into leasing companies. Mergers and consolidation in China Two major events are especially critical to the course of airline competition in China-Beijings 2000 "Three Airline" policy guidance that called for the Chinese flag passenger carriers that had begun service in the years since the break up of CAAC to consolidate into three groups led by Air China, China Southern and China Eastern, and this years sale of Hong Kong Dragonair by CNAC (Air Chinas principal shareholder) to Cathay Pacific, which in return took a large minority shareholding in Air China. The short-term objective of "Three Airline" policy was to facilitate (in a politically acceptable manner) a major restructuring of smaller carriers (China Northwest, China Northern) with unsupportable levels of debt or other serious management deficiencies. The longer-term objective was to expand the Chinese flag share of international traffic by creating multiple carriers that could develop the scale and management skills to compete with foreign carriers and their well established Asian hubs. It was hoped that each of the three could utilise their large respective home market bases (Beijing, Guangzhou and Shanghai) and other inherent strengths (lower costs, domestic feed) to compete internationally; and to gain experience from that competition that could strengthen their overall financial performance. It is too soon to render a final verdict, but at the moment both elements of this policy appear to have failed badly. There is a fundamental disconnect between extreme concentration and the basic economics of domestic Chinese aviation. The Chinese market has none of the major features that led to even moderate concentration in other settings. Domestic hubs make no sense; Chinese geography has none of the characteristics found in the American Southeast and Midwest (a rich mix of small markets) that dictated the development of hubs such as Atlanta and Chicago. Southwest-style networks seem ideally suited to provide the service and low fares the market wants, and point-to-point networks can support many more competitors than hub networks. The economics of Chinese long haul and domestic markets are totally different; any attempt to succeed internationally could totally undermine the cost discipline and operational simplicity needed to succeed domestically. While there is considerable long-term potential, the market today is a tiny fraction of domestic demand, and major expansion of (still uncompetitive) international service may take years to pay off. Asia already has an overabundance of large gateway hubs. For Beijing, Pudong and Guangzhou to succeed internationally they will need a strong advantage serving flows to and from interior Chinese cities, and must also be able to compete for the long haul flows now transiting Narita, Singapore, Incheon, Dubai and elsewhere. Beijings desire to develop more internationally competitive carriers is fully understandable, but a government policy emphasising domestic mergers and industry consolidation was the wrong way to go about it. While intended to strengthen Chinese carriers on both the domestic and international sides, the "Three Airline" consolidation policy has managed to combine the worst of both worlds. It has undermined the cost discipline and operational standardisation the domestic market required, without creating meaningful domestic long haul feeder networks at any the three hubs, or doing anything to address the deficiencies of the three airports (capacity at Beijing, layouts unsuitable for transit hubs at CAN/PVG, CANs close proximity to HKG, poor domestic feed at PVG). It is unlikely that China Eastern and China Southern could have ever become viable long haul competitors, but CNACs sale of Dragonair dealt the final death blow to any hopes that may have existed. Cathay Pacific will now have overwhelming advantage connecting interior Chinese cities to long haul destinations, while Air China will continue to dominate the large Beijing-long haul market. Cathay and Air China have not only strengthened themselves, but the industry as a whole gains from the reduced threat of hopeless MU/CZ expansion. Without significant feed, China Eastern will be limited to whatever long haul flights the local Shanghai market can support. China Southern can operate regional services to Guangzhou, but will struggle to operate and develop any significant base of profitable long haul services. Nothing in the CX/KA merger is exploiting artificial competitive constraints, and there are still many strong Asian hubs competing with Beijing and Hong Kong. There are some risks of future collusion between Cathay and Air China; hopefully the cross-shareholdings will be managed in a way to prevent this. These failures highlight the problems governments usually face when they try to override market forces in order to engineer a particular airline industry structure. There is a tendency to presume an ideal industry structure that can deliver strong economic performance over many decades, when (as the US experience demonstrates) growth and profits depend on a highly dynamic process, with totally unexpected changes in business models and cost structures regularly emerging. Government engineering also tends to be biased towards the interests of the largest, most politically adept carriers and the more "glamorous" parts of the business (premium and international service), even when this threatens the efficiency of much larger parts of the industry. The international carriers focus on how to get governments to rig the easiest possible market conditions. (The same pattern was seen before deregulation when the US CAB gave excessive preference to Transcon carriers and Pan Am, without understanding the short/medium haul routes that were the actual heart of the industry). It is difficult to predict how the Chinese industry will develop in the near future. Sensing the vulnerability of the Big Three, five new carriers following LCC approaches have recently begun service, and investors are pursuing a number of other LCC-type startup opportunities. A strong case can be made for reversing the domestic concentration policy and greater segregation of the two (domestic/lLCC and international/complex) business models, but it is not clear whether these new startups will be able to drive that process. Rather than passively cede a large part of the market to CZ and MU, CNAC and Cathay have developed a market-based response, which Beijing appears to have accepted. It is not clear whether China Southern or China Eastern understand that the "Three Airline" path is already dead, and that it is up to them to figure out a new one. Eastern adaptations of the western LCC model The LCC model is working in the Asian context as evidenced by the rapid growth of Malaysia-based AirAsia, the emergence of Air Arabia in the Middle East market and the ambitious plans of Air Deccan, Kingfisher and others in the Indian market. The most basic question facing these LCCs is how to adapt US/European models to local conditions. AirAsia For AirAsia in Malaysia, the core strategy is clear: stick as closely as possible to the Ryanair model, using high-density 737-300s, high aircraft and personnel utilisation, secondary airports where possible, rigorous cost control, very aggressive pricing (including promotional fares at less than 1 Ringitt or 25 US cents), internet-based distribution, and high profile marketing featuring the media-friendly chief executive, Tony Fernandes. This does not mean that there are not major obstacles to LCC development in Southeast Asia. As Tony Fernandes points out, the airports, initially at least, hate AirAsia, many local politicians and regulators still regard the airline with deep suspicion, and traditional full-service competitors dont have to worry about niceties like antitrust legislation. AirAsias main base is at the new Kuala Lumpur International Airport (KLIA), which is not only expensive but also further from the city centre than the old Subang airport. The airline would love to relocate to Subang, and Fernandes is lobbying the government to this effect. The government, however, still seems to prefer the option of an LCC-dedicated terminal at KLIA. The airport strategy is imaginative. For example, AirAsia uses Senai airport just across the Malay/Singaporean border as its alternative to Changi (though the Singaporean authorities have so far blocked a bus service from Senai to the Singapore city centre). AirAsia flies to Macau airport although the large majority of passengers are actually travelling to/from Hong Kong. Cost-conscious passengers are clearly not deterred by the ferry trip between the two ports. International expansion will almost certainly come though more franchise deals, enabling it to developed from new bases in Southeast Asia, maybe the Indian subcontinent and eventually China. Early this year, the carrier set up Thai AirAsia in Bangkok, in which it holds a 49% stake. Thai AirAsia operates domestically within Thailand and internationally to Macau, Malaysia and Singapore. Acceptance of AirAsia by those in power follows traffic trends - AirAsia is on schedule to carry 3m passengers this year. Vested interests can be mollified by pointing to the fact that almost all of AirAsias growth appears to have come from stimulated traffic rather than stealing from the flag carrier MAS, which has also grown in recent years. Airports can be made to appreciate that volume growth can be guaranteed by AirAsia and persuaded to concede on landing fees. Security forces have to be educated about ticketless travel in places where travellers have previously been unable to get into terminals without the correct travel documentation. Investors see in AirAsia the possibility of a Ryanair-type growth in revenue and profits and so in valuation. An IPO on the Kuala Lumpur stock exchange is planned for late November, which will see about 30% of the airline floated at around 1.40 Ringgit ($0.37) a share, which should raise between $230 and $310m, according to local analysts estimates. The total value of AirAsia therefore is being put at about $900m. This compares to Ryanairs current stockmarket valuation of just over $4bn. Ryanair has a fleet of 71 737s (57 -800s and 14 -200s) with 98 737-800s on firm order. AirAsia intends to use the funds from the IPO to finance an order for at 50+50 737-800s or possibly A320s, to supplement and replace its current fleet of 20 737-300s. Air Arabia Air Arabia has pursued more of an easyJet approach. Based in the Emirate of Sharjah, which is the Emirate just north of Dubai, all its 14 routes are by definition international. It flies to main city airports (there generally being no secondary alternatives) and pays rack rates and expensive ground handling charges (there being no choice), but Sharjah Airport is a key asset. Located just 30 minutes away from the centre of Dubai, not much further than Dubai international, Sharjah Airport is uncongested and low cost, as Sharjah Airport Authority owns 60% of Air Arabia. Air Arabia is unique in being the first flag carrier to have been designed on clear LCC principles - in terms of its point-to-point network, its aircraft utilisation, its crewing ratios, its internet-based distribution, its simple pricing structure and yield management system, its standardised A320 fleet, its slim management structure and its outsourcing of the maintenance function to GAMCO. Adel Ali, the CEO, is also a media-friendly personality. In its first year of operation (to November) Air Arabia will have carried about 0.5m passengers at an average load factor of 77%, which is well above budget (Aviation Economics was responsible for the business planning for the airline which went from concept to first flight in eight months). It is clear that there is strong demand for budget air travel within the Middle East from various sources - Middle Eastern and expat leisure travellers attracted by Dubai, cost-conscious businessmen, students, migrant workers, etc. - which Air Arabia is managing to fulfil. It is an intelligent flag-carrier for the Emirate, which has limited oil reserves - in contrast to the new flag-carrier of the Emirate of Abu Dhabi, Etihad, which appears to be aiming for global A380 dominance, replicating the full-service, long-haul models of Emirates, Gulf Air and Qatar Airways. However, Air Arabia does face constraints on its growth, related to the bilateral regimes of the region. Most of the Gulf Cooperation Council (GCC) countries adhere in theory to an open skies regime, which means that there should be no barriers to expansion on services to Qatar, Bahrain and Muscat. Lebanon also has a liberal regime. But countries like Saudi Arabia and Kuwait, also GCC members, stick to restrictive, traditional air service agreements with frequency and capacity caps. Sri Lanka stipulates minimum turn-around times of 90 minutes at Colombo (Air Arabia mitigates this by scheduling Sharjah-Colombo flights during the night). Rights to India, a potentially huge market, have not yet been granted. The airline currently cannot get into Jordan, another important market. As with AirAsia, Air Arabias approach is to grow wherever possible, in the process proving the attractiveness of the LCC product to the Middle East market. The regulatory barriers are frustrating but eventually they will be lowered. Investors, meanwhile, are starting to look at the carrier with interest, and a fund raising exercise may well be need in the next few years as the carrier expands with new A320s. Air Deccan and Kingfisher India should be the next big LCC market. The countrys middle class is variously estimated at 150-200m out of a total population of over one billion yet domestic air travel is anaemic - this year total domestic traffic will be about 15m passengers, and a large percentage of those will be connecting to international flights. With the major population centres (Mumbai, Delhi, Bangalore, etc) located 1.15-1.30 hrs flight time apart, and with a slow and overloaded rail system (which nevertheless manages to transport 15m passengers a day), the market would seem ripe for LCC entrants. Currently the market is divided up among three full service, interlining carriers - Indian Airlines, Jet Airways and Sahara - but there are also new entrants - Air Deccan and Kingfisher. Air Deccan is based at Bangalore, the centre of Indias booming IT industry, which attracts young, relatively affluent workers from all over the subcontinent. Air Deccans mission is to link the regions and it has done this recenty with a fleet of six ATR 42s. However, this August it leased three A320s from SALE, the first of which is now operating Bangalore-Delhi. Its fleet plans include another two A320s and another 15 ATR 72s. Kingfisher is a start-up with clear ambitions - its fleet plans call for 12 A320s by the end of 2005, and it has already committed to four new aircraft from GECAS. Although its headquarters are in Bangalore, its base will probably be Mumbai. Kingfisher is flirting with frills like IFE on its aircraft and will cooperate with Indian Airlines in several areas, outsourcing maintenance to the flag-carrier and apparently sharing some check-in facilities. This new airline is part of the whole Kingfisher lifestyle concept. Kingfisher beer is Indias leading brand (and has a following in the UK) but direct advertising of alcohol is prohibited in India. So the Kingfisher Group has created a lifestyle brand by, for example, sponsoring Bollywood movies, and the airline will be designed to be compatible with the marketing message. Sahara Airlines has a similar role - it is a highly visible symbol of the huge Sahara micro-banking empire in India, which specialises in small-scale loans and saving accounts. So it could be argued that neither Kingfisher nor Air Deccan (because of its split fleet) is a pure LCC start-up. There are other plans for Ryanair-type airlines, which one might think would be ideal for India, but these may or may not materialise. The downside of Indias huge demand potential is its bureaucracy and regulation. Start-up carriers have to negotiate the traffic allocation rules, whereby if an airline flies a metro route like Delhi-Mumbai, it has to allocate a certain percentage of the metro ASKs on other inter-state routes and a further percentage on regional routes in the northeast and a further percentage on intra-regional routes. Earlier this year a government commission recommended the replacement of this absurd system with a Public Service Obligation subsidy system, but since then the government has changed, with the Congress Party unexpectedly gaining power. There is also the excessively high price of jet fuel in India and the restoration of an import tax, which could add 48% to the cost of operating lease rentals.